How do you define a high quality stock investment?

At least for me, a high quality stock investment is the one that exhibits the following three qualities:

1. High Quality Financials
2. High Dividend
3. High Dividend Growth

I'm a value and dividend growth investor which means I only invest in stocks of companies that are of high quality and pay a growing dividend.

You may ask why I only invest in dividend paying stocks?



Well there are two main reasons for this. First, I want to invest in a stock or company that pays me to wait for a bigger return over time. Second, I like my investments to generate regular income, so that I don't have to work for someone else. If you have been reading my blog, you probably already know that I've retired early, so the second reason is really important for me.

Therefore, the focus of my investment strategy is to generate a dependable and growing income without ever having to dip into the principal. This strategy is also known as Dividend Growth Investment (DGI).

A DGI investor does not worry about short-term ups and downs of the market or the stock price, instead he/she focuses on the long-term growth of their investment assets and the growth of the income generated from those assets. If you know what a day-trading is then think of DGI as a complete opposite of day-trading.

So now we have establish what a DGI is. The next question to ask is how do we pick stocks that are good for long-term income generation while also increasing the size of our investment?

The answer of this question lies in the three qualities I mentioned at the start of this blog post: high quality, high dividend, and high dividend growth.

High Quality Financials

How do we define a high quality stock? A high quality stock is one that has a growing earnings spanning over many years, a strong low debt balance sheet, and plenty of free cash flow.

In other words, a company/stock with strong fundamentals or financials and a proven history of maintaining such high quality fundamentals through both ups and downs of economy and their respective industry.

Let's take a look at an example of such a stock: Johnson & Johnson (stock ticker: JNJ):


JNJ has grown its earnings (the Green area above) for 20 years straight, per the FastGraph. Even the last two recessions have not been able to slow down this company.

The other thing to note is the low debt level of only 23% Debt/Cap ratio which results in S&P Credit Rating of AAA. A credit rating of AAA is the highest rating a company can get in the US and there are only two companies in the entire US stock market that possess or are worthy of a AAA rating.

Do you know the other company with a AAA rating? It's Microsoft. Johnson and Johnson and Microsoft are the only two companies in the stock market with the highest S&P credit rating of AAA.

From the above chart, it's easy to see what a high quality company looks like in terms of its earnings growth and credit rating or debt level. The other thing to look at is the cash flow growth since dividends are paid out of cash flow and not earnings.

The chart below shows the Free-Cash-Flow (FCF) generated by JNJ over the last 20 years. As you can see, the FCF has mostly been growing with the exception of a few years when it dipped a bit. But overall the company has been generating a strong and growing cash flow year after year which speaks for a sound and growing business.

The light green line in the chart indicates dividend which has been growing in an almost straight line indicating a constantly growing and dependable dividend.



High Dividend

By high dividend, I'm referring to a starting high yield. This is the dividend you lock into when you buy a given stock at its current price. For example, at yesterday's JNJ stock price of $123.21, an investor buying JNJ stock would receive a dividend yield of 2.6%. This is not terribly high, but if you compare it to S&P 500 yield of around 1.8%, the JNJ dividend yield looks pretty good.

For a high quality company like JNJ, a 2.6% starting yield is considered high. Now if you were lucky enough like me, you would have picked up JNJ shares when it was yielding 3.0+% back in 2011 and 2012.

Too much high dividend is also not a good thing. For a standard corporation (C-corp), a dividend higher than 5% is considered very high and likely points to higher risks and fundamental problem with the business.

I typically like my starting yield for a c-corp to be no more than 5%. Only exceptions are REITs where I would look for higher than 5% yield and that is mainly because of the pass-through tax structure and non-qualified tax treatment of dividends from REITs.

Having a reasonably high starting yield allows for a bigger compounding of dividend much sooner vs. a lower starting yield. However, a high yield should not be at the cost of quality.

4% vs. 2% starting dividend with the same 11% Dividend Growth Rate
High Dividend Growth

The dividend growth is the bread and butter of DGI investment strategy. The idea is that if you buy a stock in a good quality company that raises its dividend year after year at a rate that is substantially higher than the going inflation rate, you are essentially creating a growing money making machine that will only increase its cash output overtime.

There is also a concept of re-investment of dividends. The idea is to re-invest the dividends back into the stock instead of using it as an income which then adds a compounding effect to the overall growth of the total return. A total return is equal to Dividends + Stock Price Growth.

What does this compounding of dividends look like at different growth rates over time?

Dividend Growth at two different dividend growth rates
The above chart shows dividend growth of a $10,000 investment with the same starting yield of 2.5% (similar to JNJ) but with different dividend growth rates (11% vs. 3%). Dividends are re-invested.

Note that JNJ has a 20 year dividend growth rate of 11%.

The huge difference in the dividend payout over the years between the two lines above is due to the difference in dividend growth (compounding) rates, despite both having the same starting yield. It is therefore, important to look for dividend paying stocks that have a high dividend growth rate and not just a high starting dividend.

A stock that grows its dividends at a rate of 10% will have its dividend payout approximately double every seven years. So imagine seeing your dividend income double every 7 years.

Conclusion

It takes time for the compounding of the dividends to become substantial; however, with the right combination of high quality fundamentals, high starting dividend, and a high dividend growth, the dividend compounding machine can rev up at a much faster pace, generating growing dividend cash flow year after year. When buying dividend paying stocks, don't fall for low quality high dividend stocks as they would be the first ones to cut their dividends during a downturn.

If you have discipline and patience then over time you can generate large amounts of wealth by simply investing in high quality dividend paying stocks and letting dividends re-invest over the years. It's a proven and sustainable wealth building method.

Disclosure: I am long JNJ and an avid DIG investor who does not compromise on quality of his investments.

Comments

  1. Thanks for the interesting post. Solid explanations like this help me very much as a starting DGI.

    ReplyDelete
    Replies
    1. Thank you for reading Mr. Robot, I'm glad you found it helpful.

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  2. As a dividend growth investor I primarily look at the "dividend safety" of a particular stock to determine its "quality." Of course, there are many metrics one can judge a stock on and it does take an objective and subjective approach when finally defining what a good quality stock is.

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